The Writing Is On The Wall... And We Should All Read It

The "Shiller P/E" is much in the news of late, and, as ConvergEx's Nick Colas suggests, with good reason. It shows that U.S. equity valuations are pushing towards crash-worthy levels. This measure of long term earnings power to current price is currently at 25.3x, or close to 2 standard deviations away from its long run median of 15.9x. As Colas concludes, the writing is on the wall and we must all read it. Future returns are likely going to be lower. Competition for investor capital will get even tougher. That’s what the Shiller P/E says, and it is worth listening.

Via ConvergEx's Nick Colas,

With all the investor attention on this measure, you don’t hear much about how it should inform corporate capital allocation and investor relations. Since stock prices are essentially a conversation between the owners and managers of capital, the Shiller P/E should have a place in the boardroom as well.

For example, should companies engaged in buybacks be more careful at these levels, and how do they explain that caution? And what about managing investor expectations for future returns on the business, and therefore its underlying equity? After all, the higher the Shiller P/E, the more likely that future returns will run below historical averages. In short, this is not just a useful tool for investors – it should also inform corporate capital planning and communication.

On the table in my den I have a plaque with Mercedes-Benz and Chrysler hood ornaments glued to the top. It is a deal toy – those commemorations that investment banks give out to the people who work on a specific transaction. You see them littering the officers of corporate treasurers and chief financial officers, bankers, and private equity professionals. The more toys, in theory, the more experience the person has. And the more elaborate the toy, the more creative the 28 year old investment banking associate who really did all the work getting that deal across the finish line.

You could tell that the merger of Daimler and Chrysler was going to fail by just looking at those hood ornaments on the deal toy. Daimler-Benz mounts its famous three pointed star (for land, sea and air transport) on a spring, so that in the case of an inadvertent knock it pops back up unharmed. The corporate name and laurel wreath on the base is done in a lovely blue lacquer worthy of a piece of jewelry. In contrast, the Chrysler hood ornament feels flimsier, has no spring mount and no lettering. One sharp blow and you just know the thing would snap two. And there’s really nothing wrong with either engineering ethos – they are just different approaches for different markets. But culturally, they are like oil and water.

Of course, it didn’t help matter that the merger occurred in 1998, right at the peak of the North American auto profit cycle. Chrysler got over $40 billion for the company in Daimler stock. Nine years and one forced CEO (the architect of the deal) departure later, Daimler sold Chrysler to private equity firm Cerberus for $6 billion. And two years after that the company filed bankruptcy. You could, in essence, time the tops of every market for the last two decades on when Chrysler changed hands.

The U.S. stock market has its own “Chrysler Indicator” in the form of the Shiller Price/Earnings ratio. First developed by Nobel Prize winner Robert Shiller for his book “Irrational Exuberance” in 2000, it measures the current price of the S&P 500 as a multiple of 10 year average corporate earnings. It is essentially what old-school analysts would call an earnings power ratio, since it incorporates good and bad years into one across-the-cycle measurement. A few points here:

The current reading on the Shiller P/E is 25.4x. Looking at a time series back to 1880 (available here: http://www.multpl.com/shiller-pe/) this is quite expensive. The mean observation is 16.5x, and the median is 15.9x. The cheapest-ever U.S. stock market was in December 1920 at 4.8x, and the most expensive was in December 1999 at 44.2x.

For you bell-curve fans out there, the standard deviation of the 1,600 monthly observations back to 1880 for the Shiller P/E is 6.6. That puts 95% of the distribution between 3.3x and 29.7x. In other words, at the current reading of 25.4x we are knocking on that upper bound. Put another way, levels above 25 only occurred once before the mid 1990s, and that was going into Black Tuesday 1929. And the Black Monday 1987 crash happened with a Shiller P/E south of 20.

Now, a few words of “Maybe this time is actually different” caution. First, stock valuations and interest rates are lashed together like unwilling participants in a three legged race at a corporate retreat. Long term rates are still near historic lows, so stock valuations do have the oxygen to survive at these elevated levels. Second, accounting standards change like the wind, so comparing reported earnings in 1914 to 2014 is always going to be difficult. Thirdly, the S&P 500 posted its one and only quarterly loss in 2009, so perhaps that 10 year earnings record is too pessimistic. Lastly – and giving the bearish case a little room to run here – Federal Reserve policy in the form of bond-buying does prime the market’s liquidity pump in a unique and unpredictable way. This has been positive for stocks, but the story isn’t over yet.

Even with those caveats, the Shiller P/E is a clear voice in the wilderness calling for investor caution. History may not repeat itself, as the old saw goes, but it often rhymes.

Turning back to the Chrysler example for a moment, what if corporate managers paid as much attention to the Shiller P/E as investors should and increasing actually do? Are there points in the cycle where the smart corporate money just waits out the froth? Some thoughts on this question:

At the heart of the question is the concept of expected future returns. The real reason that investors value the Shiller P/E is because it is a reliable forecasting tool for what the market will do over the next few years. At current levels, for example, average real 3 year future returns are only 5% or so (see the sources at the end of this note for the graph).

The analog in the boardroom (rather that the trading room) is the Equity Risk Premium (ERP). This calculation has its own guru, NYU Finance Professor Aswath Damodaran. His calculations show something similar to the Shiller P/E: companies should assume that investors require a higher rate of return during periods of crisis than during times of exuberant confidence. Interestingly, he comes to observation through a very different set of exercises ranging from stock versus bond return data to surveys of investors and corporate managers to expected future cash flows and assumed discount rates.

For the most recent month, Damodaran pegs the U.S. Equity Risk Premium at 5.1% based on trailing earnings, which puts the expected rate of return on the U.S. stock market at 7.7% with the current 10 year Treasury yield of 2.61%. That’s based on your friendly neighborhood Capital Asset Pricing model with a beta of one, a.k.a. the market beta.

There’s a large gap between what the Shiller P/E tells us to expect – sub 5% returns – and the 8% (rounded up) on the corporate side. Essentially, the expected future return of stocks used in the boardroom to plan capital projects is about double what an investor using the Shiller P/E has any logical right to expect.

If that sounds like a lot of inside baseball/jargony hogwash, rest assured that there are real world applications that make this conversation highly relevant today. For example:

Mergers and Acquisition Analysis. Simply put, it is a good time to be a seller if you are a public company listed on a U.S. exchange. You won’t find that observation in your internally-created discounted cash flow analysis, because it likely uses a standard cost of capital number such as the ones Damodaran calculates. More realist expected returns – such as those that correlate to Shiller P/E measures – mean that any significant future gain will be much harder to achieve.

The corollary is that buyers of public companies should use their own stock as a major source of capital in any transaction. Yes, M&A has a spotty record of creating shareholder value, but don’t compound that challenge with financial leverage at this point in the cycle. Use stock. Notably, the tech sector has clearly gotten this memo.

Stock buybacks. This one is tricky, because there is so much misinformation about what stock buybacks are supposed to accomplish. The clear-eyed view is simple: companies buy back their stock when they have excess cash flow that cannot be effectively reinvested in the business. Also, this extra capital is generally cyclical in nature, so managers don’t want to create or up a dividend just to cut it back with the economy weakens.

This puts many companies in a tough spot, however, because cyclical cash flows tend to occur (spoiler alert) when things are good and the stock is strong. Buying the stock back at these points in the cycle may lead to some embarrassing moments on future quarterly financial calls if it declines precipitously from an economic slowdown or (worse yet) shock to the system.

The Shiller P/E is flashing a modestly cautious yellow hue to buyback programs at the moment. At the same time, activist investors everywhere are also on the lookout for cash-rich companies to engage, and buybacks are often the first page in their shareholder value playbook. In the end, companies are a bit between a rock and a hard place at the moment. Strong free cash flow plus activist investors equals the need to keep buying back stock even at lofty levels. Let’s just be careful out there.

Investor relations. This most underappreciated corporate function is where the rubber hits the road on the topic of Shiller P/Es versus standard cost of capital calculations. In a nutshell, it has never been more important to underpromise and overdeliver results. Not since 2007, anyway. Remember that future returns are more likely to be less-than-5% rather than the 8% you see in internal corporate presentations. The rising tide of the last five years is unlikely to continue, so every public company will be in fiercer competition for investor capital as future returns drop.

In summary, the times change and everything from capital allocation to investor relations have to change with them. That is potentially a tough lesson for many companies to embrace, since a consistent approach to capital planning and communication is comforting to many managers. Still, the writing is on the wall and we must all read it. Future returns are likely going to be lower. Competition for investor capital will get even tougher. That’s what the Shiller P/E says, and it is worth listening.

I wonder if the stock market will actually "collapse". If the banks are holding tremendous amounts of liquidity in reserves could they not open the lending window to many of these corps to facilitate stock buy backs? Could that not put a floor under prices? I'm more sure of Housing Bubble 2.0 imploding than the S&P. Real Estate, despit the best efforts of the FED, still requires some fundamentals in regards to peoples ability to pay rent or afford the monthly mortgage nut. This is true of commercial and residential. The stock market is a bunch of bits floating through computer networks backed buy a currency that is itself backed by nothing. I could see a flash crash brought on by HFT and other factors but I could alsop see stocks trading at insane PE ratios indefinitely. Not saying it will, but can anyone say it won't?

i closed out my S&P indexed IRA from when I was 18 today, at 1895. havent touched it in 11 years until now. withdrawing my principle when the sale cleares on thurday. stocks can't trade on insane PE ratioes forever. the consequences of ignoring reality cannot be avoided forever

I do wonder if they can keep it going until there is a change in the currency system. With no real retail investor action what is to stop them? In a world where the oligarchy is awash in liquidity it's like Steve Wynn playing blackjack in his own casino, win or lose at the table he wins. Now I can see the argument that the vertical trajectory must peter out at some point. But given that all manner of price discovery is being thwarted I believe the Dow and S&P might see just enough price action to rape the muppets here and there allowing the insiders play a fun game of "hot potato" they never really lose. I admit to not being a stock savant, but from the outside looking in it just seems like a bunch of numbers in a computer that they control.

im not a stock savant either, im a stock idiot. WHich is why I bailed on it, much later than I should have. I just don't want to play hot potato with steaming piles of bullshit anymore. Price discovery will not be pretty. I may look stupid for calling it quits on the market over the next few months, as markets may go up moar, but over a longer period, participating in this market is a fools errand

This article fails to mention the widespread accounting shenanigans going on out there that no one hears much about. Even in the late 90's internet bubble many companies earnings were totally due to increases in stock prices. It's going to be a shock when it all comes out in the wash, but it's all happened before.

Eventually wealth will be so concentrated that there won't be enough to go around for the peasants and when the peasants can't pay rent or buy food all hell will break loose. My bet is the governments will use the banks to confiscate all the big money and what they plan next is depends on to which 'they' we are talking about.

What is the Schiller P/E during the times the US has engaged in QE? Oh, there weren't other times prior to 2008? Guess no one knows what is crash worthy in that environment. I think we all know it's coming down someday, but days like today shows there is plenty of fiat left to throw at this thing

Earnings? WTF do we need earnings for? As many of the tech companies have shown us (yeah I'm talking to you amazon) we don't need any stinking earnings. Look at the banks, they have been bankrupt for five years now and they're still around. A little accounting gimmickry, some financial engineering, a paid off regulator, and most importantly a never ending sea of liquidity from the fed and suddenly you have companies that can linger forever. Besides, they can always blame the weather.... That one never seems to get old.

we are so far beyond earnings and gdp etc. and so far off into some other galaxy of zirp and "where else you gonna put your money" etc. that articles like these are just auto generated so Nick whatever his name is can justify his existence.

BTW to answer you question earlier. Resurger was on the thread where Tyler asked "Does this look normal?" And Resurger posted "fuck you Tyler. You act like this just happened". I responded to resurger's post and the next thing I know it and he was gone. Vanished like a midget in Madonna's vagina.

See that is the big difference between you and I. I usually go with the token Shawshank "up and vanished like a fart in the wind". But not you. Nope you have to go with midget in Madonna's vagina. That will always be the fundamental difference between you and I.

I like Resurger, I don't know why the need to lash out at Tyler over that one. What a waste to get booted over that. Interesting though, our other mutual friend who is no longer on here pointed this out to me...

"am i crazy or does this chart actually show ES taking off before the VIX and therefore leading it?"

hang in their fonz, you are one of the few who still make this site worth reading.... a year ago I would spew on the screen once a week reading the posts here. Not so much anymore.... shit is getting more and more irrational, and more and more twilight zone every day... Not sure if reading this stuff makes me crazier or keeps me grounded, and off the koolaide.

Thanks Gator. I appreciate it. I have talked about this before, so no need to get too deep into it. But if you have not read it, you should read "The Long Walk" by Richard Bachman (it was an alias for Stephen King).

i mentioned before, this site usually posted everything by jim quinn from the burning platform, but it didnt post a story or two where quinn really goes after google, and google ads, and their censorship, which was posted after google dropped them. He lays into google for attempting to censor him, and ZH, despite their usual posting of his work, and anything anti establishment, they don't post this. and TBP had been down for a while now, after posting about DOS attacks on their site. And it becomes really obvious why "tyler" doesnt post this kind of thing if you are using firefox with ghostery as your browser-tyler is full of shit, since this sight has more tracking cookies, including google ads, than any other sight i go to. things that make you go 'hmmm'. i mention this since it seems similar to what doc says.

This is a big site with big traffic. It costs real money to power the servers. It costs real money for staff to keep the site running. It costs real money to run everything. Advertising is a must unless you and your friends want to pony up 20-30 per month for the "privelege" of reading/posting. Somehow that model does not work.

"For profit", as a slander, is bullshit.

Life costs money, no one works for free.

Amost everything is for profit. Even NFP -they need to earn money from sources other than donations. They have to earn enough to cover costs, meaning they earn something. If they earn more than they spend then it gets donated.

NFP causes are "for profit" also. They just stop at what it takes to run the business.

This site is worth over $80M, and takes in over a million dollars every month.

You can Google it.

This site is another product to buy into. They've done a commendable job of identifying their target market, and pandering to it. It can be fun, but don't be under the illusion that it's something its not. This site exists to make money. That doesn't make it inherently good or evil, but it is a fact.

So those that pine away for doom and gloom, simply remember where you're spending your time and ....

"As it happens, recently elevated margins are embedded into nearly every earnings-based valuation multiple, including the Shiller CAPE. We can see this by calculating the profit margin embedded into Shiller earnings (the denominator of the CAPE, divided by current S&P 500 revenues [as a % of GDP]). That figure is about 6.5% [of GDP], compared with a historical norm of about 5.4%."

And it does use an inflation factor, which of course if you use the government figure it is absurdly low. So it's not made for these times, and probably not honestly calculated on top of that. Have a nice day.

aka "PE 10", aha, I'd seen those around and was never interested enough to find out what they meant. How about that?

"but days like today shows there is plenty of fiat left to throw at this thing"

I like what you had to say so what makes you think there is sooo much more fiat to throw at it? Feds pulling back, do they spook things if they start up again?, can it really go on much longer (1-3 years)?

"but days like today shows there is plenty of fiat left to throw at this thing"

I like what you had to say so what makes you think there is sooo much more fiat to throw at it? Feds pulling back, do they spook things if they start up again?, can it really go on much longer (1-3 years)?

Why do I keep hearing The Eagles song 'Take It To The Limit' playing when I look at that graph? Something tells me we got a long way to go, and that all rational thought has long since been thrown out the window by TPTB. With algos driving everything and 44.2x being the record, this baby looks undervalued by a mile to them I would imagine. S&P 3000 here we come!

People think this is like something they have seen before, they are shorting and thinking it has to come back down soon, it doesn't, it won't, it can't. The FED will start outright purchasing E-minis if they have to.

Everybody knows it, but no greedy fucker wants to be the first one out. Oh yes, there shall be weeping and gnashing of teeth, but I shall successfully wring out the last few percent and escape wrath, they say...